finance essay

Impact Discount Rate Changes On Stock Market Return Finance Essay

Published: 23, March 2015

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Stock exchange performance has attained significant role in global economics and financial markets, due to their impact on corporate finance and economic activity. For instance stock exchanges enable firms to acquire capital quickly, due to the ease with which securities are traded. Stock exchange activity it can be in the form of dividends or profits, as a company gets its dividends and profits in the form of their share holders in the secondary market. Well there is a definite change in the market as with the behavior changes with the discount rate, changes can be technical or non-technical. Technical changes refers to the internal changes and non-technical as external changes which are mostly related to the behavior and response of the customers and consumers.

Equity returns also measured by the industrial index respond rather rapidly to the unexpected announcements of discount rate changes. Not only affecting equity returns, the unexpected discount rate changes also contribute to higher market volatility. An unexpected discount rate change also induces trading which is more supportive of the contention that public information causes price changes with trading. Increased trading volume due to unexpected public information, however, occurs only in the current period. Whenever, the market is not efficient, stock prices adjust to new information slowly and it is possible to generate abnormal profits. Financial market volatility is important for investors' confidence, for port-folio selection, and for the pricing of both primary and derivative securities. Market volatility is not related to existing public information such as expected discount rate change announcements.

Karachi Stock Exchange 100 Index (KSE-100 Index) is a stock index acting as a standard to compare prices on the Karachi Stock Exchange (KSE) over a period of time. In formative representative companies to calculate the index on, companies with the maximum market capitalization are selected. On the other hand, to ensure maximum market representation, the company with the maximum market capitalization from each sector is also incorporated..

1.2 Problem Statement

1.3 Research Hypothesis:

1.4 Outline of the Study

The aim of the study is to observe This Study is observing on Karachi Stock Exchange (KSE). The Karachi Stock Exchange is a stock exchange situated in Karachi, Pakistan, established on 18 September, 1947 it started with 5 companies with a capital of Rs. 37 million. It is Pakistan's biggest and oldest stock exchange, with a lot of Pakistani as well as overseas listings. Its present premises are placed on Stock Exchange Road, in the heart of Karachi's Business District. KSE starts with a 50 shares index. As the market develops a representative index was needed. In poor political condition, social issues, financial and other problems, KSE played a very important role in the financial system of Pakistan. KSE 100-index showed a return of 40.19% and became the sixth best markets in the year 2007. It gets a biggest milestone by touching of KSE-100 Index level of 15,000 for the foremost time in the history of Karachi stock exchange on 20 April, 2008. On the other hand, the raise of 7.4 percent in 2008 build-up the best performer in all the emerging market. The KSE 100TM Index closed at 9645 points on 19 June, 2010. Although by 30th July total market capitalisation of the KSE reached Rs2.95 trillion, approximately around 35 billion dollars

CHAPTER 2

LITERATURE REVIEW

As it can be figured out by the models of stock market and about the interest rates, value of share in the stock market, maturity of the bonds with short run and long run and the value of the capital as well as the factor of production, All these things influence a great deal towards the changes as well as the demand and supply model. Equilibrium is also there, which is basically an intersection, the point where the quantity of supply equal to the quantity demands. Output and interest rates plays a bigger role in the discount changes, as from the different policies, laws and models have been mentioned in the previous studies. If prices are fixed country can never faced inflation because of the nominal and real rates. Output depends on the stock market and fiscal policy (Blume, 1994).

The stock market is the ratio of steady-state profit to the steady-state interest rate. If the money increases in the market the steady-state effects are quite clear, Output and stock market are higher in the equilibrium. The higher money stock lowers the real interest rate and thus the cost of capital. This was all about a monetary expansion under fixed price. We find that in the pre-79 period, there was no securities market response to either technical or nontechnical changes, while in the post-79 period there was no response to technical changes (Hardouvelis and Gikas, 1987).

Discount rate changes will affect market rate and equity returns if such changes brings information about either short- or long- run monetary policy objectives. So an in increase in the discount will definitely help to attract more and more people towards the policy, and there will be a huge amount of change in the customer's and client's response towards it. As a result, current (spot) and expected short-term rates rise in reaction to reduced short-run money growth. Long-term rates and forward rates may also increase to reflect the higher expected short-term rates. It doesn't have much impact over the long-term rates as it has on short-term rates just because the monetary policy and consumer's response (Maberly, 1992).

Short term rates makes more people attractive and kind of working well for the secondary markets, so mostly they all rely on the short-term rates, as they prefer short-term rates than long-term rates. And short-term is the one which affect a great deal. The impact of discount rate changes on equity prices can operate through two possible channels. This is most readily seen by viewing the value of the firm as. To some extent discount rate increases (decreases) result in increases (decreases) in interest rates. It has also based on the capital or investment as well, capital can fall or rise just because of the stock prices, stock prices has an ultimate effect on capital and economic activity can be disturbed too, that also can be altered due to this price change. If the capitalization rates and cash flow expectation are affected by discount rate changes, these effects will also work in the same direction. From previous studies we have an idea that stock prices declines to be associated with discount rate increases (Ederington and Lee, 1993).

Considering the New York stock exchange, the stock return data are the daily percentage return on the New York Stock Exchange value-weighted index and is denoted SP. The interest rate data are for constant maturity Treasury securities and include eight different maturities: 90-, 180-, and 360-day bills and three-, five-, seven-, ten-, and twenty-year bonds. These rates are obtained from DRI, who compile them from the Federal Reserve Board Statistical Release from DRI. These eight interests are used to calculate seven forward rates in addition to the 90-day bill rate. The stock price coefficient for the post-79 period suggests a 1 percent increase (decrease) in the discount rate will result in a decline (increase) of 1.06 percent in stock prices. A similar finding in reported for the interest rate data. Only one interest rate series evidences a significant market reaction in the pre-79 period, while six of the eight interest rates indicate a significant market response over the post-79 period (Gerety, and Mulherin, 1992).

Although the early researches result indicates that the real issue is whether the observed announcement effect, regardless of the monetary policy regime, indicates market inefficiency. In classification of the discount rate changes from the previous discussion we have evaluated that to assess properly the announcement effects of discount rate changes, it is necessary to distinguish technical from nontechnical changes. There are several short comings with this approach that limit its usefulness in predicting discount rate changes and cast substantial doubt on the assumption of discount rate erogeneity (Lee and Bong, 1992).

Researches rely on two different methods to classify discount rate changes. The best model, both in terms of in-sample fit and prediction of actual discount rate changes, related changes in the discount rate (measured in basis points) to the spread between the Fed Funds rate and the discount rate. Nonetheless, if the model incorporates the relevant information set, then by construction the forecast and optimal predictions based on available information and, therefore, rational. Through the study of different modules we came on to know in conclusion that the purpose of this has been to reconcile previous findings of both an endogenous discount rate and discount rate announcement effects with market efficiency (Harris, 1986).

By classifying discount rate changes as either technical or non-technical, and recognizing that the latter are (at least) partially endogenous, it is argued that, within the framework of market efficiency, the discount rate can fail tests of statistical erogeneity and still exhibit announcement effects. The empirical evidence of this paper supports this view and suggests that previous studies were missing specified by not controlling for the purpose of discount rate change. The evidence also implies that the common assumption contained in virtually all theoretical and empirical macroeconomic models, that the discount rate is either purely endogenous or purely exogenous, is inappropriate. This also specifies market only react when there appears to be a shift in policy- in the discount rate. At least from this standpoint, one cannot rule out the discount rate as a useful tool of monetary policy. Eventually, our results support the existence of efficient markets based on the dual findings that only nontechnical changes are characterized by announcement effects and that virtually the entire market adjustments occurs by the end of the announcement day (Jones, 1994).

From previous studies the issue of monetary neutrality has long been debated by financial economists. There was evidence been brought in to the market which says that increases in the growth rate of money raises stock returns? Monetary policy affects the real economy, and whether its effects are quantitatively important, remain open questions. These questions by examining the effects of monetary policy innovations on stock return data. Theory posits that stock prices equal the expected present value of future net cash flows. To examine the relationship between monetary policy and stock returns, a variety of empirical techniques are employed. The size portfolios are useful for investigating why monetary policy matters, if in fact it does. If monetary policy has real effects, one reason for this could be that it affects firms' balance sheets. To investigate whether monetary policy affects size and industry portfolios, both impulse responses and innovation accounting methods are used. All the results in table one to four measures the effects of monetary policy shocks on nominal stock returns. In considering the question of monetary neutrality, we are interested in whether monetary policy affects real stock returns. Thus rather than complicate the analysis by considering the best way to measure expected inflation we focus on results using nominal returns. Through the different systems results reported are robust to minor changes in the specification. When total reserves are dropped, employment growth or unemployment is used instead of industrial production growth, the non stationary variables are first-differenced, and the number of lags is changed (Marshall and David, 1992).

There was another approach to identifying monetary shocks is Data and Methodology which is been made to the use of Federal Reserve statements and other historical documents over the period to identify exogenous changes in monetary policy and the responses of real variables. This narrative approach has recently employed to assemble a much larger sample of monetary policy shocks. An alternative way is used to test whether monetary policy affects stock returns (Morse, 1981).

A growing number of papers in both the economics and finance literature focus on the effect of economic news on asset returns. Nonetheless, there seems a wide gap between these two literatures. These elements of surprise in one particular type of news announcements of short-term interest rate decisions made by the Open Market Committee affect the volatility of the stock market in the short term. Relationship between monetary policy and daily stock market volatility from two vantage points: days around regularly scheduled meetings of the stock market committee, the main monetary policy making body and days of actual policy decisions involving the target level of the federal funds rate (Fama and Kenneth, 1995).

Turning to the days of actual policy decisions regardless of whether they were announced on regularly scheduled meetings days. Some evidence was found that such decisions tend to boost volatility in the stock market. The effect of policy decisions is greatest that exclude those decisions that were fully anticipated by market. Besides identifying monetary policy announcements as an important source of short-run volatility in the stock market, this will also addresses broader issues in the finance literature. In particular, higher interest rates induce higher leverage ratios, which in turn increase the risk associated with holding stocks and the volatility of stock returns (Patell and Wolfson, 1984).

all models combined two different approaches widely used in the monetary economics and finance literature. In particular, in analyzing the market's response to scheduled and unscheduled announcements, a potentially interesting issue is whether the corresponding impulse response functions for volatility are significantly different. Other issues that also merit further consideration include a closer look at the relationship between first- and second- moment responses to policy news and the explicit analysis of risk premiums around announcements days (Penman, 1987).

From all these models and theories, have come to know that anything that happens in the secondary market, it does have an impact over the entire economy as we have gone through from the different examples across the world. Even if it is pre-announcement, monetary policy or whatever, stock market does change its state according to the circumstances and events. Pre-announcements are also made as precautions that are for safety announcements for the share holders of the companies. Due to this they can easily draw their amount and will not have to see further more difficulties. Unpredictability or volatility is always there in the market, when the investors just to keep on guessing for the right time to invest and stock holders wait for the right time to buy shares of the companies and all this process makes things more complicated especially for the investors and then it effects the stock market. Monetary policy on the other hand takes things more attractive for the investors and share holders that they believe their money is in safe place so they would love to invest as long as they are sure about the monetary policy (Stoll and Whaley, 1990).

Policies are always made for the betterment of the people who are your clients or customers as per organization requirements, it also refers to the trust that how much they trust on their policies that people could come and invest. Banks do the same thing; the only thing they sell is trust, because as many people trust on you as they will go on to be their customers. Many of the sources indicate that there is a connection between news and stock prices, finance literature highlights that too. The finance literature focus on economic announcements per se, without controlling for the element of surprise in such announcements, might help to explain why so many studies have failed to find a significant link between market volatility and economic news. Either by implicitly assuming that the conditional volatility of stock returns is time invariant or by simply leaving its time-varying nature unspecified, monetary economists have failed to consider a potentially significant effect of policy surprises on the short-run behavior of the market (Wood and McInish, 1985).

Equity returns also measured by the industrial index respond rather rapidly to the unexpected announcements of discount rate changes. Not only affecting equity returns, the unexpected discount rate changes also contribute to higher market volatility. An unexpected discount rate change also induces trading which is more supportive of the contention that public information causes price changes with trading. Increased trading volume due to unexpected public information, however, occurs only in the current period. Whenever, the market is not efficient, stock prices adjust to new information slowly and it is possible to generate abnormal profits. Financial market volatility is important for investors' confidence, for port-folio selection, and for the pricing of both primary and derivative securities. Market volatility is not related to existing public information such as expected discount rate change announcements (Richard Roll and Stephen Ross, 1986).

CHAPTER 3

RESEARCH METHOD

This chapter explains the methodology used for the research study. The main research data set is used in this paper consist of KSE 100 index listed on Karachi Stock Exchange. It is the data for last ten year's 2000 to 2010 for every monetary policy has been announced and see the impact after five days which is available on the Karachi Stock Exchange Website. Data would be collected through the website and business recorder website. This chapter also discusses the methods to evaluate validity and reliability of research for the factors associated with the

3.1 Method of data collection:

The secondary data which was used in this research was available on the website of Karachi Stock Exchange from 2000 to 2010.

3.2 Sample size and Sampling Technique:

In this research, data from the year 2000 to 2010 has been taken as a sample size. The data collected through Karachi Stock Market and State Bank of Pakistan

3.3 Instrument of Data Collection:

This research was carried out through Secondary Data.

3.4 Statistical tool used:

In order to measure the relationship between the variables stock market return and discount rate and impact of discount rate change on stock market return, Regression is used as a statistical tool in this research. SPSS software is used to evaluate the relationship between the two variables

CHAPTER 4

RESULTS

Hypothesis Testing

Table 4.1

From the above Durbin Watson value, it has been clarified that there was an existence of auto correlation in the data set. In order to resolve the issue we have generated the lag variables of the dependent variable up to the level 2.

Table 4.2

Form the above table we can observe the value of the Adjusted R Square is .934 or 93.4%. It means that 1 unit change in the set of independent variables brings out the 93.4% change in the variation of dependent variable. With the inclusion of the lag variables in the data set, the problem auto correlation has been resolved. The Durbin Watson value mentioned in the above table is 1.964 closer to 2. Value closer to 2 means that there is no auto correlation exists in the data set.

Table 4.3

From the above table we can observe that the significant value of the above ANOVAs test model 2 is less that 0.05. It means that the data is suitable for the application of regression model.

Table 4.4

The above table shows the coefficient value of the analysis. As it can be observed that, the significant value of the discount rate is less than 0.05 it means that the change in discount rate has a significant impact on the stock therefore; the Null hypothesis is not rejected.

At 95% confidence interval level the significant value of alpha/constant is 0.000 it means that the in the absence of all the variables the minimum return of the KSE is equal to the alpha value.

The Beta value of lag 1 is 5376.550 it means that the today returns from the stock market is dependent on the stock market returns after the announcement of last monetary policy. For e.g. if the current stock return are equal to 1 the stock returns after the announcement of the next monetary policy is 5376.550 times of the current stock returns. The relationship of the lag 2 stock returns is vice versa of the lag 1 stock returns. It has a negative relationship with the current stock returns.

Graph 4.1

The above diagram shows the trend of the KSE index and the change in discount rates for the last 10 years in the country. On a whole an upward trend has been observed in the KSE 100 index it is due to the increase in the FDI investments as well as the development in the financial sectors. The change in the discount rate shows overall a mix trend, we can observe a huge peaks and valleys in the graph. In our research, we have not found any significant relationship among the announcement of change in discount rate and stock returns. Some of these factors are political situation of the country, foreign direct investments, Law and order situation and most importantly exchange rate. Collectively, all these factors are contributing in the stock returns. However, change in the discount rate do impact the stock returns but, not in the short run, in the long run the chances are quite high that it does impact on the stock returns in Karachi Stock market. The reason behind the Long term affect is that, the change in the discount rate affects the profitability of the companies in the next coming quarters so, immediately the affect in the stock returns are not massive that are in the long run.

4.2 Hypotheses Assessment Summary

The hypotheses of this research study are based on variables like stock market return and discount rate intraday. The significant value is less than 0.05 It means that the data is suitable for the application of regression model.

S.NO.

Hypotheses

F

SIG.

RESULT

H1

CHAPTER 5

CONCLUSIONS, DISCUSSIONS, IMPLICATIONS AND FUTURE RESEARCH

5.1 Conclusion

As anticipated, expected discount rate changes, representing existing public information, have no impact on the trading volume for the current period nor does for any other periods. Public information also induces trading only in the current period but not in the future periods. More trading has occurred during the decreasing discount rate periods than the increasing discount rate periods as evidenced by the significant parameter.

5.2 Discussion

This research shows that the change in the discount rate shows overall a mix trend, it can be observed a huge peaks and valleys in the graph. In this research there was no significant relationship found among the announcement of change in discount rate and stock returns. The reason behind this is, other than monetary policy there are lots of other factors that are contributing towards the stock returns in Karachi stock market. Some of these factors are political situation of the country, foreign direct investments, Law and order situation and most importantly exchange rate. Collectively, all these factors are contributing in the stock returns. However, change in the discount rate do impact the stock returns but, not in the short run, in the long run the chances are quite high that it does impact on the stock returns in Karachi Stock market. The reason behind the Long term affect is that, the change in the discount rate affects the profitability of the companies in the next coming quarters so, immediately the affect in the stock returns are not massive that are in the long run. In this research it has been identified more accurately that if and when the stock market responds to the release of the discount rate change information. More importantly, studying the market volatility and trading volume sheds additional light on the information literature. Equity returns while the expected changes generally have no bearing on the equity returns.

5.3 Implementations

For practical implementation, this research can be used to analyze the impact of Discount rate Changes on Stock Market Return as The effect of discount rate changes on stock market; however, the effect of expected changes on equity returns is insignificant. Abnormal trading volume occurs only in period.

5.4 Recommendations

Pre-announcement, monetary policy or whatever, stock market does change its state according to the circumstances and events. Pre-announcements are also made as precautions that are for safety announcements for the share holders of the companies. Due to this they can easily draw their amount and will not have to see further more difficulties. Unpredictability or volatility is always there in the market, when the investors just to keep on guessing for the right time to invest and stock holders wait for the right time to buy shares of the companies nd all this process makes things more complicated especially for the investors and then it effects the stock market.

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